What Is the Difference Between a Hobby and a Business?

Some people think that a freelance business is really a hobby if you work from home, but is it? What about if you keep unusual business hours or work part-time? Do these things mean you’re not really in business?

Some so-called gurus say that working from home or keeping unusual hours means you don’t have a real business.

While many people may have their own opinions about what makes up a business, in many countries there is an actual legal answer to the question. In the United States, that answer comes from the Internal Revenue Service (IRS).

It’s important to get the right answer to this question, because it has broad implications regarding your taxes and bookkeeping. In this post, we’ll discuss this important topic and provide some additional resources that you can turn to with questions.

Are You Trying to Earn a Profit?

(Information provided here is based on available information at the time it was written and should not be considered legal or tax advice. For your specific situation, consult with a legal or tax specialist.)

This is the main question that the IRS wants to know when deciding whether your activities should be a classified as a business or a hobby. To determine this, they will first look at your last five years of business (including the current year). If three of those years (including the current year) show a profit, then the IRS will most likely consider that you have a profit motive.

With creative people (and that includes many freelancers) the line between a business and hobby can sometime be blurry. Sometimes what started out as a hobby can transition into a business, so it’s very important to understand the rules.

Can You Be Unprofitable and Still Be a Business?

You may think that a string of unprofitable years means that your business will automatically be reclassified as a hobby, but that isn’t necessarily the case. You may still be able to demonstrate that you have an intent to earn a profit even if your business has not earned a profit yet.

To demonstrate a profit motive for your business, first of all make sure that you keep excellent records. It may help your case if you can provide some of the following information:

The amount of time you put into the business

The percentage of your total income that comes from the business

The reason for any losses

Changes and improvements you’ve made to the business

Evidence of your own knowledge in the field

A record of any past business successes including any profits made in earlier years

The current and anticipated future value of any business assets

It should go without saying that you should be keeping excellent bookkeeping and tax records. If this is not your strength, you may need professional accounting help.

There are some legitimate reasons why a business might have an unsuccessful year, so don’t panic if your business had an unprofitable year.

What If My Activities Are Classified a Hobby?

What happens if, despite your best efforts, the IRS reclassifies your freelancing business as a hobby?

As I mentioned earlier, there are some implications for your taxes and bookkeeping–the main one being that there is a limit to deductions for expenses related to hobby activities. Specifically, loses from your hobby cannot be used to offset other income. These deductions appear on Schedule A of the 1040. There are also certain business deductions, such as the deduction for start-up expenses, that do not apply to a hobby.

More Resources

For freelancers in the U.S., the best place to get more information and the most updated information is on the IRS website. Here are three IRS publications you may wish to review:

This post detailing 5 Common Business Tax Myths from About.com’s Small Business Canada guide discusses the issue from a Canadian perspective.

Your Thoughts

The actual reason I wrote this post is because I saw a tweet on Twitter with misinformation about what constitutes a business. The tweeter was sharing their opinion, but I knew from prior research that their opinion in this instance was wrong. This is one area where it’s not enough to simply have an opinion–it’s important to get this right.

I based this post mostly on information available for U.S. freelancers. However, other countries may have their own specific rules about what determines a business. If you’re a non-U.S. reader, share the rules in your country in the comments.

If you’re in the U.S., have you turned a hobby into a business? Share your tips in the comments.

Comments

If your local codes indicated a permit or business license requirement in order to operate a business from one’s home it would suggest a business expense. Of course some locations indicate that operation or use of home for business reasons are a violation of code.

If you want to see something interesting you should Google “home occupation.”

Michael–Thanks for sharing your related post. :) It’s interesting to see what the rules are in Canada. Most people don’t understand what the distinction is. I hope this post (and the comments) help to clarify things.

I know this blog caters to all freelancers, but from a writing standpoint, I’ve noticed that the start up costs are so small that it’s easy to make a profit at the end of the year… There’s not much you have to BUY to set up shop and say “I’m a freelance writer.” Of course, this has both advantages and disadvantages.

Hi Allena–I agree that the start up costs for many freelancers can be relatively low. However, it would still be possible for a new freelancer to lose money if they were overly optimistic and spent more than they earned. (New computer, new software, advertising expenses, new office furniture, legal fees, etc.)

Richard, Thanks for sharing how HMRC looks at freelancers.

In the U.S. the downgrade to a hobby is significant because it means that the freelancer will still have to report the income, but cannot declare the expenses.

Thank you Laura for this post on what differentiates a hobby from a business. I think that it makes sense that when there is profit from the activity it can be seen as a business. Nonetheless, it can also be remarked that all businesses are not necessarily profitable.

Pretty sure in New Zealand it’s a similar deal – if you set out to make a profit, it’s a business. I know the IRD cracked down some time ago on people who sell things on Trade Me (NZ’s major online auction site) for profit, because up until then there was a bit of a grey area around paying tax on goods sold there. But that only applies to people who fit certain criteria – selling your old clothes etc. doesn’t count of course.

From what I’ve read, there’s a whole set of criteria that can be used to determine if it’s a hobby or a business, including things like how much time is spent on the activity, frequency of transactions etc, but the main one seems to be intent of profit.

Anyway, you’re right enough, HMRC won’t downgrade your business to a hobby. Though, from the view of being able to claim the expenses, that seems like a good thing.

Let’s remember that this post is not legal or accounting advice, but just my take on the issue based on what I’ve read in the IRS regulations.

@Gold Nope. Not saying that at all. You brought up local regulations (which naturally should be followed, as all laws pertaining to small businesses should). But that is a red herring to the topic of the post, which deals with whether a business is considered a hobby or a freelancing business accord to IRS rules.

I enjoyed the legal clarification. I have an additional question regarding hobby vs. profession when it concerns customer perceptions. Since many freelancers work in a craft that is also a popular hobby customers may undervalue your work. I think the assumption is “since you do this for the love of the craft any money I pay you is a small bonus (or to cover the cost of materials).” Also, when the tools of the trade are easy to acquire and have technical innovations that make them easier to use many devalue the work professionals do. My work is in TV production. It has been difficult to get and maintain respect from those outside the profession. The work we create is very easy to consume which gives people the perception that it must be easy to make.

[...] What Is the Difference Between a Hobby and a Business? “It’s important to get the right answer to this question, because it has broad implications regarding your taxes and bookkeeping. In this post, we’ll discuss this important topic and provide some additional resources that you can turn to with questions.” [...]

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